James Pethokoukis

Politics and policy from inside Washington

FCIC report: 10 causes of the financial crisis

January 27, 2011

The other dissent (written by Keith Hennessey, Douglas Holtz-Eakin, and Bill Thomas) to the main Financial Crisis Inquiry Commission report identifies 10 causes for the meltdown. They run through them in a WSJ op-ed:

Starting in the late 1990s, there was a broad credit bubble in the U.S. and Europe and a sustained housing bubble in the U.S. (factors 1 and 2). Excess liquidity, combined with rising house prices and an ineffectively regulated primary mortgage market, led to an increase in nontraditional mortgages (factor 3) that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to pay.

However, the credit bubble, housing bubble, and the explosion of nontraditional mortgage products are not by themselves responsible for the crisis. Our country has experienced larger bubbles—the dot-com bubble of the 1990s, for example—that were not nearly as devastating as the housing bubble. Losses from the housing downturn were concentrated in highly leveraged financial institutions. Which raises the essential question: Why were these firms so exposed?

Failures in credit-rating and securitization transformed bad mortgages into toxic financial assets (factor 4). Securitizers lowered the credit quality of the mortgages they securitized, credit-rating agencies erroneously rated these securities as safe investments, and buyers failed to look behind the ratings and do their own due diligence. Managers of many large and midsize financial institutions amassed enormous concentrations of highly correlated housing risk (factor 5), and they amplified this risk by holding too little capital relative to the risks and funded these exposures with short-term debt (factor 6). They assumed such funds would always be available. Both turned out to be bad bets.

These risks within highly leveraged, short-funded financial firms with concentrated exposure to a collapsing asset class led to a cascade of firm failures. The losses spread in two ways. Some firms had large counterparty credit risk exposures, and the sudden and disorderly failure of one firm risked triggering losses elsewhere. We call this the risk of contagion (factor 7). In other cases, the problem was a common shock (factor 8). A number of firms had made similar bad bets on housing, and thus unconnected firms failed for the same reason and at roughly the same time.

A rapid succession of 10 firm failures, mergers and restructurings in September 2008 caused a financial shock and panic (factor 9). Confidence and trust in the financial system evaporated, as the health of almost every large and midsize financial institution in the U.S. and Europe was questioned. The financial shock and panic caused a severe contraction in the real economy (factor 10).

Me: I really like that they looked globally to try to find the common elements between the crises here and there. It is pretty hard to ignore this graphic:



The list of “causes” should have included comparisons to previous great financial manias. This would have observed that since the 1825 example the final phase ran some 12 to 16 months against an inverted yield curve.

The problem during such a boom is not rising interest rates. This confirms that the boom is on. The problem arrives when the curves reverses to steepening, with T-bill rates declining.

This fateful reversal started in May 2007, which was the 15th month of inversion.

The rest, as the saying goes, became history. There are two “rules” that worked. Short rates plunge during the initial bear market and economic contraction. The notion that “cuts” in the Fed rate will reignite a boom is not supported by history.

The other “rule” is that the post-bubble recession starts virtually with the bear market. Using NBER determinations, the 1873 bubble ended in September and the recession started that October. The 1929 bubble ended in that September and the recession started that August. The 2007 bubble ended in October and the recession began in that December.

There are other “rules” but that would take a lot of space.

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